FOMC Acts As Expected

Thursday, June 30, 2005

The Federal Reserve Open Market Committee (FOMC) has acted as expected and raised the Fed Funds rate for the ninth time in a row 25 basis points to 3.25 percent. Most important: The Fed kept to its "measured" pace in the statement which indicates another raise to 3.50 percent at its next meeting on August 9.
A word-by-word comparison of the latest two statements (see below) shows that only two sentences were marginally changed.
In sentence 3 the FOMC sees the a firm expansion and a gradually improving labor market despite higher energy prices. It erased its former worries about a slowdown in spending growth.
In the next sentence the FOMC shortened its inflation outlook, saying "pressures on inflation have stayed elevated," after it had said before that "pressures on inflation have picked up..." The longer term outlook on prices was described unchanged and called again "well contained."
Altogether the FOMC has done a good job. Nothing in this statement could unsettle markets. This announcement can be seen as a calming primer for a quiet summer holiday season '05. The only thing that could keep phones ringing on the beach is another surge in energy prices that cannot be ruled out, given the fact that oil markets worry already now about the supply for the cold season.
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Comparison Of The Two Latest FOMC Statements
JUNE:The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 3-1/4 percent.
MAY: The Federal Open Market Committee decided today to raise its target for the federal funds rate by 25 basis points to 3 percent.
JUNE: The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity.
MAY: The Committee believes that, even after this action, the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity.
JUNE: Although energy prices have risen further, the expansion remains firm and labor market conditions continue to improve gradually.
MAY: Recent data suggest that the solid pace of spending growth has slowed somewhat, partly in response to the earlier increases in energy prices. Labor market conditions, however, apparently continue to improve gradually.
JUNE: Pressures on inflation have stayed elevated, but longer-term inflation expectations remain well contained.
MAY: Pressures on inflation have picked up in recent months and pricing power is more evident. Longer-term inflation expectations remain well contained.
JUNE: The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal.
MAY: The Committee perceives that, with appropriate monetary policy action, the upside and downside risks to the attainment of both sustainable growth and price stability should be kept roughly equal.
JUNE: With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
MAY: With underlying inflation expected to be contained, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured.
JUNE: Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
MAY: Nonetheless, the Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.
JUNE: Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Edward M. Gramlich; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.
MAY: Voting for the FOMC monetary policy action were: Alan Greenspan, Chairman; Timothy F. Geithner, Vice Chairman; Susan S. Bies; Roger W. Ferguson, Jr.; Richard W. Fisher; Edward M. Gramlich; Donald L. Kohn; Michael H. Moskow; Mark W. Olson; Anthony M. Santomero; and Gary H. Stern.
JUNE: In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 4-1/4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.
MAY: In a related action, the Board of Governors unanimously approved a 25-basis-point increase in the discount rate to 4 percent. In taking this action, the Board approved the requests submitted by the Boards of Directors of the Federal Reserve Banks of Boston, New York, Philadelphia, Cleveland, Richmond, Atlanta, Chicago, St. Louis, Minneapolis, Kansas City, Dallas, and San Francisco.

Fed Funds 1995-2005

GRAPH: Federal Funds and several key interest rates. Courtesy of Bankrate.com
Who Wins, Who Loses?
Markets took the statement in an orderly fashion. Bonds were barely moved with the benchmark 10-year Treasury yielding 3.96 percent after 3.95 percent the day before. With the FOMC's move the yield curve has further flattened to 71 (94) basis points.
The 1/2 percent decline in stocks corresponds with the proven fact that rising interest rates have never helped the stock market in the long term.
The rate hike in general favors people and institutions who carry no debt. The first ones to feel the pinch will be adjustable rate mortage (ARM) holders or shoppers who will see higher rates at the next adjustment date. So will home equity line of credit holders, credit card debtors and all others who purchase on credit.
ADDENDUM: The biggest loser of the rate hike is of course the USA as it will have to offer it's creditors higher yields from this day onwards. Most of the US budget deficit is financed with short-term maturities up to six-months, so the rollover will come sooner than the government wishes for.
NOTE: The Federal Reserve Board has posted the schedule for the FOMC's meetings in 2006 here.
UPDATE: Barry Ritholtz has an interesting post that contests the good GDP growth numbers released on Wednesday. He calls the strong upward revision "fishy." Is there more optimism in the official releases than in the real economy?

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